Municipal bonds backed by the 1998 Master Settlement Agreement between the major tobacco companies and 46 states have long been a favored holding of individual investors due to their substantially better-than-market yields.

Because the viability of these bonds is dependant on domestic cigarette sales, tobacco bonds have been regularly downgraded by the rating agencies, as the number of smokers in the United States has declined in recent years.

On July 12th, Moody’s issued a report stating that “nearly 75% of senior tranches of tobacco settlement bonds will default should cigarette consumption in the U.S. continue on its current rate of annual decline.” This finding is consistent with the current ratings on these bonds. (Moody’s rates 79% of all tobacco bonds B1 or below.)

This week, Fitch ratings also warned that some 150 tranches of tobacco bonds could be downgraded within the next month.

Both credit agencies utilize break-even models to identify potential defaults. Moody’s model is built around cigarette sales, while the Fitch model focuses primarily on MSA payments. Although Fitch’s cigarette consumption projections are somewhat more positive than Moody’s, neither paints a rosy picture for the future of these MSA supported securities.

We suggest investors consider selling any holdings of tobacco bonds, which are now rated well below investment grade, particularly if speculation is not an investment objective.

Despite the adverse publicity, the prices of tobacco bonds have benefitted significantly from the ongoing rally in the municipal market, making this an advantageous time to sell.

James A. Klotz is the President of FMSbonds, Inc. Email the Author07/17/2012